What Is Compound Interest?

Every investor is unique, which is why a good financial planner will help you tailor your investment strategy to your personal goals. However, there is one principle of investment that applies universally: the power of compound interest to help you build wealth over time.

Often described as “interest on interest," compound interest plays a critical role in growing your investment returns or increasing your debt. To make sure you get compound interest working in your favor, it’s important to understand how compound interest works, how it is calculated, and how you can take advantage of its power to enhance your financial potential.

If you’re looking to make more informed saving, investing, borrowing, and spending decisions, you can also use our compound interest calculator to jumpstart your financial planning.

Simplify your calculations with our compound interest calculator

What Is Compound Interest?

Compound interest is interest applied to both the principal balance of an investment (or loan) and the interest already accrued on that principal balance. Unlike simple interest, which accrues only on your original principal balance, compound interest applies to your ongoing investment earnings. This creates a snowball effect, where interest is continuously earned on an ever-growing balance to accelerate the growth of your money over time.

To understand the difference between simple and compound interest, consider this example. Let’s say you invest $5,000 at an annual interest rate of 5% compounded yearly. In this case, you will earn $250 interest in year one. The following year, however, you earn 5% on both the initial $5,000 and on the $250 interest, resulting in greater overall returns which expand exponentially with each passing year.

In contrast, simple interest applies a flat rate to the principal amount without considering any accumulated interest. As a result, your annual earnings will cap out at $250 per year. Here’s what it might look like in practice:

How Is Compound Interest Calculated?

While simple in theory, calculating compound interest is somewhat more complex. Several different formulas exist but the most common one looks like this:

A = P (1 + r/n)nt

Where:

• A = The total amount you will have earned (or will owe) at the end of the period
• P = The principal amount
• r = The annual interest rate, expressed as a decimal
• n = The number of times interest compounds each year
• t = The amount of time over which the money grows, in years

 Prefer not to use pen and paper? Use our compound interest calculator.

Another useful tool for estimating compound interest is the Rule of 72. Under this rule, you would divide 72 by the annual interest rate to find out how long it will take for your investment to double. Using the example above, if you divide the 5% return on your $5,000 investment by 72, you see it would take roughly 14.4 years to double.

The Impact of Compounding Frequencies

As the formula above shows, you need several variables to properly calculate compound interest. One of the most critical is the frequency at which interest is earned.

Interest can compound on various schedules, such as daily, monthly, quarterly, or annually. The more frequent the compounding, the greater the total interest earned. Let’s revisit the earlier example but include different compounding frequencies in the mix.

After one year, an investment of $5,000 at a 5% interest rate would yield:

• $5,250 if interest compounds annually
• $5,255 if interest compounds monthly
• $5,556 if interest compounds daily

While the differences may seem minor over a year, they become significant over longer periods. For instance, if this same investment were left to grow for 30 years, you would have $21,609 with annual compounding versus $22,406 with daily compounding.

Compound Interest in Financial Planning

It’s worth mentioning that all the calculations so far track the growth of an initial investment only, without considering the impact of making ongoing investments. Not surprisingly, regular contributions further amplify the power of compounding by boosting your principal balance. Even modest consistent investments can grow substantially over time, enabling you to build long-term wealth and mitigate the impact of inflation.

This underscores the role that compound interest can play as part of your financial planning strategy. By investing regularly in retirement accounts, such as 401(k) plans or individual retirement accounts (IRAs), you can potentially reap the benefits of compound interest over decades, enhancing your ability to maintain your lifestyle into your retirement years.

Another way to maximize compound interest is to start saving early. Setting aside even small amounts every month can result in significantly higher savings over the course of years. For instance, if you save $100 per month starting at age 25 with a 5% annual return compounded monthly, you will have accumulated roughly $153,975 by age 65. At the end of that time, your principal investment will have been only $48,000.

Conversely, if you try to catch up by investing $350 per month starting at age 45 with the same 5% annual return compounded monthly, you will only have $145,410 at age 65, despite having invested a principal amount of $84,000.

By investing early and often, you can harness the power of compound interest to effectively turn your investments into a passive stream of income over the long term.

Keep in mind, however, that the same logic applies to debt. If you owe high-interest loans or are carrying a credit card balance, the power of compound interest would work against you, increasing the amount of interest you owe over time.

The Bottom Line

Compound interest is a cornerstone of wealth building and financial security. By understanding how it works and applying it strategically, you can grow your savings, plan for retirement, and reduce your debt burden.

Whether you’re a seasoned investor or just starting out, we can show you how to leverage the power of compound interest to reach your long-term financial goals.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. 

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